Emerging Markets – Caught in the Crossfire

US monetary policy has missed its mark and it is a handful of emerging markets that look set to pay the price

The big guns of monetary policy used to combat sluggish economic growth are about to be put away but the real damage may be just about to kick in.  The Federal Reserve adopted loose monetary policy to get the US economy moving again but it is elsewhere where the effects have been felt the most.  Having benefited more from the loose monetary policy than the intended target, some emerging markets look set to suffer as a policy reversal prompts US investors to stage a destructive retreat back home.

Danger zone

The proverbial printing presses at central banks are like the heavy artillery of monetary policy.  Central banks such as the Federal Reserve had been pumping out cash to buy bonds as part of quantitative easing.  Yet, the US economy had failed to fire up with companies unwilling to invest while spending remains weak.  Investors with cash in hand turned their sights overseas and targeted emerging markets where economic growth was still perky. 

The surplus US dollars helped to lower interest rates for borrowers in many countries which had not gotten caught up in the global financial crisis.  The reduced borrowing costs pushed up lending elsewhere despite not having the same effects in the US economy.  The muted effects of monetary policy in the domestic economy prompted the Federal Reserve to unleash even more firepower.  Money, like some things, is fine in moderation but the bombardment of US dollars inadvertently created its own minefield. 

Borrowers in emerging market were only given access to cheap cash by borrowing in US dollars for a short period of time.  This was fine as long as the prospects for the US economy were poor and US dollars were readily available.  But any significant improvement in the US economy would see investors shift their money back.  A stronger US economy would also push up the value of the US dollar and make it tougher for overseas borrowers to pay off any debts in US dollars. 

Collateral damage

Like solider stationed in a hostile region, investors were set up to bail when the opportunity arose.  Just the mere mention by the Federal Reserve in May 2013 that quantitative easing might be coming to an end was enough to trigger a rush by investors to get their money out.  Six months of market volatility followed even though quantitative easing did not actually end until October 2014.  With the Federal Reserve now mulling lifting interest rates up from their low levels, more upheaval seems likely.

This is because money often does more damage on the way out compared to the gains when it is initially welcomed.  Yet, the lure of cheap cash is too much to ignore.  Even the financial sectors in richer countries have shown themselves to be unable to cope when too much money is on offer.  Less developed banking systems in emerging markets are often even worse at putting any cash to good use.  This increases the likelihood that many borrowers will struggle when US dollars are harder to come by. 

As the aftermath of the global financial crisis has made painfully clear, a swift end to a lending boom is not something easy to get over.  In its attempts to deal with an US economy sagging under the weight of excess debt, the Federal Reserve has inflicted the same woes on others who are less able to deal with the consequences.  Like any form of warfare, it is the innocent victims that suffer the most.

Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.